Review: Seeing through bankers’ woolly thinking

The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

How much capital do banks need? Ask the Basel Committee of global banking supervisors, and it will recommend 3 percent of total bank assets. Ask tougher observers like the UK’s banking commission, and you’ll hear 4 percent. But ask Anat Admati and Martin Hellwig, the economists behind The Bankers’ New Clothes, and you’re in for a shock: they’re after 30 percent.

Bankers greet this kind of talk with a bemused shake of the head. Hiking capital, they claim, will just mean cutting the amount of lending in the economy by a proportionate amount. Super-high capital ratios would slash returns on equity to such an extent that banks would struggle to attract new private-sector investors to help increase lending. Ask anyone in the City and they will repeat, as if in a trance, that equity is expensive and pushes up the cost of providing credit.

Admati and Hellwig tackle this argument head on. First, they argue that the idea of capital and lending being in opposition is baloney: capital – which should really be called “equity” to avoid confusion – is in the liability column of banks’ balance sheets. It helps to fund assets – or loans – rather than sitting unused in a box. Banks with more equity can do more lending, not less.

The authors concede that banks’ ROE figures would fall if they had more equity. But any bank maintaining a 30 percent capital ratio will be significantly safer, which means that the cost of that equity should also come down. This is the “Modigliani-Miller” theorem, which states that in an idealised world companies would be indifferent between funding themselves with debt or equity. More loss-absorbing capital should also make it less likely that taxpayers will have to bail banks out.

Admati and Hellwig’s analytical rigour is convincing. So why aren’t banks voluntarily increasing the amount of equity on their balance sheets? The cynical view is that bankers have an incentive to keep capital levels low – less capital means higher returns on equity, and bigger bonuses. They spend plenty of money trying to convince politicians and the general public that equity is expensive. The authors marshal plenty of examples, reminiscent of Charles Ferguson’s depressingly plausible 2011 film Inside Job, documenting how politicians, regulators and bankers are intertwined.

But the argument for dramatic increases in equity faces a more fundamental problem. Banks are not necessarily subject to the normal dynamic, whereby debt becomes more costly as banks become more leveraged – and therefore more risky. Instead, taxpayer subsidies that mean big banks are bailed out in a crisis give them an incentive to borrow as much as possible. In the authors’ own analogy, banks are like homebuyers who put down tiny deposits on their houses but know they will get rescued by a rich auntie if anything goes wrong.

The problem for Admati and Hellwig is that this means bankers’ objections have some logic. Adding more equity reduces the proportion of their loans that can be financed with artificially cheap debt. That’s bad for bonuses and shareholders, but also for small businesses and families striving to get onto the housing ladder: their borrowing costs may go up.

There’s something rotten about this status quo, though. Even if the system enables cheaper loans, it also means bank shareholders and employees are protected from facing the consequences of their risky behaviour: taxpayers – the rich aunties – are on the hook. When bankers dismiss higher equity levels they are cynically and opportunistically confusing their private gains with what’s good for society. They are like a chemical firm carping about the cost of insuring against potential losses from toxic spillages it has itself caused.

The value of The Bankers’ New Clothes is that it sets all this out in clear and accessible terms over little more than 200 pages, without cutting corners: the notes alone are over half as long. The problem is how to get the banking firmament from where it is now to where Admati and Hellwig think it needs to be. The authors’ preference – bans on dividends to shareholders and forcible state restructurings of weaker banks – would require politicians willing to not only take on Wall Street but also explain why cheap financing shouldn’t be extended to the poor and why potentially more taxpayer money needs to go into the financial sector. The authors’ hard line on capital means they also underplay regulatory reforms that are already under way: supervisors have made some progress in safely winding up failing institutions, and while new Basel III rules may have only trebled capital requirements from a wholly inadequate starting point, they are better than nothing.

That doesn’t mean Admati and Hellwig are any less right in their analysis of banks’ failings. But the sad truth is that when confronted with a choice between a freestanding banking system and one which periodically blows up but enables artificially low borrowing rates, politicians will tend to choose the latter. That means low bank equity – and overpaid bankers – could be around for a while yet.

The Bankers’ New Clothes, by Anat Admati and Martin Hellwig, is published by Princeton University Press.

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